Suppose we define risk as as situation exposing a person to the possibility of harm or loss. There are several things we need to address once we accept that.
The one used in investment analysis is variability. That is a market issue. On any given day Mr. Market may be depressed or euphoric. The price he sets will be higher or lower depending on his mood. From history we know the returns average out higher.
Down only matters if you need the money just then.
We need a defense to our emotional reaction to things. Fear and greed are dominant emotions in the marketplace so people have come to value predictability.
Predictability just means to tighten the range within which a portfolio performs. In the market as a whole, the range for the stock market over an 8-year cycle is anywhere between about down 15% and up 25%. Most people can’t cope with that because they look too often and don’t see the long picture when they do. You should notice that the market tends to be self-correcting over time. It is nearly unheard of to find a ten-year holding of a major index including dividends, where there is a loss.
So they narrow it by including assets that trade in a narrower range. Bonds being the familiar one. You set your own range based on a single factor. Sell stocks until you sleep.
Catastrophic loss is different. You lose everything.
These losses do not correct over time. You die. Your house burns down. You injure or kill someone while driving. An airplane crashes. A ship sinks. Done once, done forever.
The decision is binary. Pay for insurance or keep the risk for yourself and save the premiums. Easy enough to analyze.
Your day-to-day work should be risk mitigation or avoidance. Like health. “Which fits into your busy schedule better, half an hour a day of exercise, or 24 hours a day of dead?”
If you know the odds, you can make money with risk, because the definition includes an upside. There is a key point though. Having the best of the situation does not mean you always win. It means if you play many times you can expect a certain result, but you know nothing about the next one.
Suppose you play a game where you have a 60% chance of winning $50. When you lose, your loss will also be $50. You expectation is come ahead by $10 every time you play. 50×60% minus 50×40%. If you play once, you might win or lose. If you play 5 times, there is a small chance you will lose all 5 times. That why wealthy people seldom take all or nothing risk.
If you play 100 times and can afford any early losses, you should expect to be ahead by $1,000. Odds even out. Clearly knowing the odds is an important part of the process and you cannot rely on intuition.
Probabilities are not intuitive. For example, if you randomly select 23 people, the odds are 50-50 that two celebrate their birthday on the same day of the year. With 65 the odds are nearly 500 to 1 in favour. Find the real probabilities before risking much.
Never assume taking risk automatically gives you higher returns. Andy Martin in his excellent book, “Dollarlogic” makes a point you should care about. “Risk does not equal reward.”
Taking serial risks when you have the best of it makes money, but you must do your homework on the probabilities.
Las Vegas is built on a house edge that averages less than 5%. It is the volume of transactions and the limits on the bets allowed, that guarantees a profit.
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